Non Deliverable Forward (NDF)

A Non-Deliverable Forward (NDF) is a forex derivative in which the underlying currencies are not physically exchanged. Instead, the difference between the agreed forward rate and the settlement rate is paid in cash.

• NDFs are commonly associated with currencies subject to restrictions or controls.
• The contract specifies a notional amount, an agreed forward rate, and a settlement date.
• For example, an NDF may have a notional amount of ₹1 crore and an agreed USD/INR rate of 75.
• If the fixing rate at maturity is 76, the difference between the contracted and fixing rates determines the cash settlement.
• NDFs are generally traded over the counter (OTC).
• They may be used for hedging currency risk or taking a view on exchange-rate movements.

A Non-Deliverable Forward is a foreign exchange contract used to hedge against or take a position on currency movements without physically delivering the underlying currency.

At the start of the contract, the two parties agree on the notional amount, forward exchange rate, fixing date, and settlement terms.

At maturity, the currencies themselves are not exchanged. Instead, the difference between the agreed forward rate and the applicable fixing rate is calculated and settled in cash, usually in a freely convertible currency such as the US dollar.

NDFs have commonly been associated with currencies such as the Indian rupee (INR), Chinese yuan (CNY), and Brazilian real (BRL). They are generally traded over the counter (OTC), so their terms can be agreed between the parties.

Businesses and financial institutions may use NDFs to manage exchange-rate exposure. Traders may also use them to take a view on currency movements without requiring physical delivery of the underlying currency.

An NDF starts when two parties agree on a notional amount, a forward exchange rate, and a future settlement date.

There is no physical delivery of the underlying currency when the contract matures. Instead, the contract is settled in cash, commonly in a convertible currency such as the US dollar.

The settlement depends on the difference between the contracted forward rate and the fixing rate specified under the NDF contract.

For example, suppose an NDF has:

• Notional amount: ₹1 crore
• Agreed USD/INR forward rate: 75
• Fixing rate at maturity: 76

Because the fixing rate of 76 differs from the agreed rate of 75, one party makes a cash payment to the other based on this difference and the contract's notional amount.

The exact payment depends on the contract's quotation convention, position, and settlement formula. The ₹1 crore itself is not physically exchanged between the parties.

This cash-settlement structure makes NDFs useful when physical delivery of the underlying currency is restricted or impractical.

Non-Deliverable Forward contracts have several characteristics that distinguish them from regular deliverable forward contracts.

• Non-deliverable nature: The underlying currencies are not physically exchanged when the contract is settled.
• Cash settlement: The gain or loss arising from the difference between the contracted rate and the fixing rate is settled in cash.
• Use with restricted currencies: NDFs are commonly associated with currencies where convertibility or offshore delivery may be restricted.
• OTC trading: NDFs are generally traded over the counter, allowing parties to agree on contract terms.
• Risk management: Businesses and financial institutions may use NDFs to manage exposure to exchange-rate movements.
• No physical currency delivery: Since settlement is based on the rate difference, the underlying restricted currency does not have to be delivered.

These features allow market participants to manage exposure to certain currencies without physically exchanging them.

Different types of market participants may use NDFs for hedging or other currency-related purposes.

1. Institutional investors: Pension funds, mutual funds, and investment firms may use NDFs to manage currency exposure arising from international investments.
2. Hedge funds: Hedge funds may use NDFs to take positions based on their expectations of movements in certain currencies.
3. Corporates: Multinational businesses may use NDFs to manage currency risk related to their operations, revenues, expenses, or investments in different countries.
4. Central banks: Central banks may participate in or influence NDF-related markets as part of broader foreign exchange and currency-management activities.
5. Exporters and importers: Businesses involved in international trade may use currency derivatives such as NDFs to manage the risk of unfavourable exchange-rate movements.

These different participants use NDFs according to their individual currency exposure and risk-management requirements.

NDFs can be useful for managing currency exposure, but they also involve risks.

• Exchange-rate volatility: Unexpected currency movements can result in losses for one side of an NDF contract.
• Counterparty risk: Because NDFs are generally OTC contracts, there is a risk that a counterparty may fail to meet its contractual obligations.
• Liquidity risk: Some NDF currency pairs may have limited liquidity, which can make entering or exiting a position more difficult.
• Regulatory challenges: Rules governing currency derivatives differ across countries and may affect how NDFs can be accessed or used.

Participants should therefore understand the contract terms, currency exposure, liquidity, counterparty, and applicable regulations before entering an NDF.

Both are currency derivatives, but their structures are different. An NDF focuses on settling the difference between an agreed exchange rate and a fixing rate without delivering the underlying currency.

A currency swap generally involves exchanging cash flows in different currencies over an agreed period.

Non-Deliverable Forwards (NDFs) allow market participants to manage currency exposure without physically exchanging the underlying currencies. Instead, the difference between the agreed forward rate and the fixing rate is settled in cash, usually in a freely convertible currency. NDFs are commonly used for currencies with convertibility or delivery restrictions. While they can help manage exchange-rate risk, they also involve risks such as currency volatility, counterparty default, limited liquidity, and changing regulatory requirements across different markets.